Will the Fed Change Course?

by oldprof

(09/14/14) After a number of meetings where the FOMC announcement merely confirmed widespread expectations, this week’s result may be different. I expect everyone to be wondering, Will the Fed change course?

Prior Theme Recap

In my last WTWA I nervously suggested that there would be a surprising focus on individual stocks rather than macro factors. This proved to be a good call, and I even had the right reasons: Apple announcements, Alibaba, and a dearth of economic news. The competing story was the surprising dollar strength at the end of the week.

Feel free to join in my exercise in thinking about the upcoming theme. We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead.

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This Week’s Theme

The scheduled highlight of this week (despite some competition from Scotland) is the FOMC policy announcement. This is one of the meetings where the Fed updates individual and consensus projections and provides additional transparency with a press conference from the Fed Chair.

The result of the modern transparency efforts is often additional confusion!

Here is what you need to know in advance:

• The forward guidance language is likely to change. Even the doves on the Fed want to communicate more data dependence rather than a calendar-based forecast. Leading Fed expert Tim Duy explains why this change would be helpful:

  The trick is to change the language without suggesting the timing of the first rate hike is necessarily moving forward.  The benefit of the next meeting is that it includes updated projections and a press conference.  Stable policy expectations in those projections would create a nice opportunity to change the language.  Moreover, Yellen would be able to to further explain any changes at that time.  This also helps set the stage for the end of asset purchases in October.  A shift in the guidance next week has a lot to offer.

• Experts at major firms vary widely in their expectations. Calculated Risk has a good summary.

• Alan Greenspan spoke to insurance company executives, explaining nine negative points about the economy. He emphasized that none could be easily fixed. Focusing on the topic where he is most expert, here was his take on the upcoming turn in Fed policy:

  We have to taper at some point, and things will only turn around once we see commercial and industrial loans tease that money out of the federal system and paid out to the commercial markets. This is a necessary condition for inflation. It is not happening yet. But it will. And when it does, Greenspan says, it will surprise us with how quickly it moves. Be prepared.

Will the Fed change course? What will be the market reaction?

As usual, I have a few thoughts to help with that question. First, let us do our regular update of the last week’s news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week’s Data

Each week I break down events into good and bad. Often there is “ugly” and on rare occasion something really good. My working definition of “good” has two components:

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially – no politics.
2. It is better than expectations.

The Good

There was a lot of very good news, supporting the general thesis of economic strength.

• Q2 GDP growth is getting revised higher. It is “massive” according to this article (Goldman’s estimate is now 4.7%) and it is spilling over to Q3 estimates.
• Deficit reduction in the US. The combination of very slow growth in spending and a brisk increase in revenues has reduced the deficit. Scott Grannis calls the 3% gap “very manageable. His analysis includes this helpful chart:

• Michigan sentiment beat expectations. Doug Short always has a fine analysis of the confidence data and his chart would be a great example for a college class or textbook on data analysis. He shows the data series, the average level, the relationship with GDP and the clear ties to recessions — all in one attractive chart.

• Retail sales met current expectations and beat estimates if you consider revisions. The market, especially fixed income, saw this as economic strength, so that is how I am scoring it. Retail was weak in Q1 and the Q2 rebound was generally disappointing. Last week’s report was a welcome sign of strength. Doug Short’s analysis explains the significant and frequent revisions. Steven Hansen at GEI sees the data as mixed. Bespoke has an interesting angle, with an emphasis on gasoline prices. When fuel prices were spiking, some observers noted that this artificially inflated retail sales with consumption that was actually negative for the economy. Now that we are seeing fuel price decreases it is important to remember that this is a drag on retail sales. Nick Timiraos at the WSJ sees lower gas prices translating quickly into other spending.

The Bad

There was also some negative news, some of which is difficult to translate into a market effect.

• Ukraine conflict turns worse. As I write this, the apparent progress toward a cease fire (noted last week) has ended. Another Russian convoy is entering Ukraine without permission. Shots have been exchanged. Also, the Treasury is expanding sanctions.
• China’s imports have stalled according to the analysis from Dr. Ed Yardeni. Imports are an important indicator of economic strength, so the data are worth following. Dr. Ed is suspicious of the report, however, partly because the data come out so promptly — much faster than other countries. We would all like to know about the Chinese economy, but it remains challenging to follow. For what it is worth, here is the Yardeni chart:

• Labor force participation might not be able to increase much according to recent research by Fed economists. I covered the significance of this issue in a recent WTWA post featuring employment. If there is little potential for increase in LFP, then we are closer to increased wage costs than Fed Chair Yellen expects. Max Ehrenfreund of The Washington Post has a good story and this chart:

• Scottish secession worries. The chance of a “yes” vote on Scottish independence seemed remote a week ago, but the polls have changed dramatically. Here is the betting line via The FT – negative as of Thursday, but very fluid. Here are the implications for investors.

• Dollar strength is a negative for some stocks. Mohamed El-Erian explains the underlying dynamics, with a nod to the Scottish jitters. The relationship between the dollar and stocks seems to involve dramatic “regime” changes. There are periods of risk off/risk on where the dollar has an inverse correlation with stock prices. The long-term relationship shows stronger stocks aligned with a stronger dollar. Brian Gilmartin does a first-rate job of translating this trend into impacts on specific stocks. Check out his analysis. Here is the key quote:

  A strong dollar benefits importers and penalizes exporters, all other elements being equal. I wish I could access the data, but I would guess that, after 2008, and the growth of BRIC’s and such in the last decade, of total US GDP, the US is a larger “net exporter” than say in the late 1990’s when the Asian Tigers collapsed, so prolonged strength in the dollar could have a net-net negative impact on SP 500 earnings over time, if the strength in the dollar is persistent.

The Ugly

Our “ugly” list for the last few weeks remains unfortunately accurate. We had headline news from all conflicts with plenty of violence and death competing for our attention. The Ebola crisis, cited a few weeks ago, continues to worsen. We may have to accept these as the “standing ugly list” so that we can consider new issues. These are all very ugly, but I want this category to be open to new entrants. If I missed something this week, please raise it in the comments!

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts.  Think of The Lone Ranger. No award this week. Nominations are welcome.

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Doug Short: An update of the regular ECRI analysis with a good history, commentary, detailed analysis and charts. If you are still listening to the ECRI (three years after their recession call), you should be reading this carefully. Doug includes the most recent ECRI discussion concerning continuing economic weakness in Japan. Doug covers the possible implications for the US.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured “C Score.”

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. Dwaine’s “liquidity crunch” signal played out as projected. This week he highlights his HILO Breadth index which he has designed to pinpoint bottoms and to warn of protracted corrections. Current readings imply an opportunity that usually shows up only once a year. Check out the full post for a description and charts.

Georg Vrba: Updates his unemployment rate recession indicator, confirming that there is no recession signal. Georg’s BCI index also shows no recession in sight. Georg continues to develop new tools for market analysis and timing. Some investors will be interested in his recommendations for dynamic asset allocation of Vanguard funds.

The Week Ahead

After last week’s avalanche of news, we have a more normal week for economic data and events.

The “A List” includes the following:

• FOMC announcement (W). Taper continues, but what signal for the future of rate hikes?
• Housing starts and building permits (Th). Any change in the sluggish housing market would be welcome.
• Initial jobless claims (Th). The best concurrent news on employment trends.
• Leading indicators (F). Widely followed indicator of economic prospects.

The “B List” includes the following:

• Industrial production (M). Confirmation for the strong ISM surveys?
• CPI (W). At some point the threat of inflation will be relevant, but it will take a few worrisome reports.
• PPI (T). See CPI.

I am not very interested in the Philly Fed, although some follow it as the first release of data from the new month. I am even less interested in the Empire index.

The referendum on Scotland’s independence could be a wild card.

Breaking news from Ukraine and Iraq has become a part of the investment landscape. These stories are having an effect, but are nearly impossible to handicap on a short-term basis.

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have five different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a “one size fits all” approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

My weekly insights often suggest a different course of action depending upon your objectives and time frames. They also accurately describe what I am doing in the programs I manage.

Insight for Traders

Felix remains bullish. Uncertainty is now more modest and is moving lower. Our Felix trading accounts remain fully invested. Broad market ETFs are also positive.

You can sign up for Felix’s weekly ratings updates via email to etf at newarc dot com.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. The current “actionable investment advice” is summarized here. In addition, be sure to read this week’s final thought.

We continue to use market volatility to pick up stocks on our shopping list. We do this because we also sell positions when they reach our (constantly updated) price targets. Being a long-term investor is not the same as “buy and hold.”

Here is our collection of great advice for this week:

Confusing politics with investing is an expensive mistake. The discussion from Tim Mullaney at MarketWatch is well worth reading for the examples. He emphasizes the mistakes from one political perspective, but he tries to make the right generalization:

The point is: Don’t listen to people who tout investments based on their politics. It’s a sure sign they lack the dispassion needed to evaluate securities and make you money.

If you or I were advisors for a political campaign we would always attack the party in power, including all of the policies. This was just as true when the GOP held the Presidency. It is fine to have strong opinions and to use those in voting and in your private discussions. Meanwhile, wouldn’t you prefer to profit no matter who is in power? That is why I recommend being politically agnostic.

Morgan Housel has a great list of things where investors should “know the difference.” Here is a good example:

You should know the difference between average and normal. You should never think “average” is what should be happening right now. The S&P 500 has gone up an average of about 9% a year over the last century. But since 1900, stocks have gone up or down more than 20% in almost twice as many years as they have gained between 5% and 10%. Nine percent is average, but chaos is normal. Same goes for valuations. They’re more likely to be swinging between some state of insanity that no one can justify than hovering near an historic average.

OK – I can’t resist providing a second oneJ

You should know the difference between a contrarian and a cynic. A contrarian knows the masses get it wrong sometimes. A cynic thinks he’s smarter than the masses all the time. 

John Woerth at the Vanguard Blog shares a list of mistakes – and also some good moves. Here is one example:

Chasing yield. One of my first fixed income investments was Vanguard GNMA Fund. I was attracted to the high absolute and relative yield and didn’t fully appreciate the principal risk that accompanied the investment. I wasn’t expecting, nor was I accustomed to seeing, the fluctuations in the net asset value of what I naively considered to be a conservative government bond fund. Experience, they say, can be a cruel teacher.

Mistake: Greed and ignorance.

Lesson: Don’t chase yield or past performance. Do your homework and have realistic expectations for the reward and risk potential of any investment that you’re considering.

Tren Griffin at 25iq has A Dozen Things I’ve Learned from Josh Brown – all good. Here is one example:

“The next time you hear someone say we’re overdue for a correction, ask them for a copy of the schedule. Unfortunately, markets are biological rather than mechanical in nature and, as such, precision in timing is nowhere to be found.” A market is more like a cat than a machine. This is what Josh is referring to when he says markets are “biological.” In more technical terms, a market is a “complex adaptive system” and for that reason trying to make short term predictions about the future is folly.  If you want to be an “active” investor I suggest a value investing approach: the occurrence of certain types of events over the long term (change in a stock price) within your circle of competence can occasionally be predicted in a way that gives you odds that are substantially better than even – but that happens rarely. When it does happen, bet big. The rest of the time, don’t bet. Accept this fact of life sooner rather than later, and you will be wealthier and happier.

Instead of worrying about market valuation, look for cheap stocks, writes Patrick O’Shaughnessy. (This was one of my themes at the SF Money Show. I know, I know. I am overdue in trying to turn this presentation into blog posts). He uses Apple’s stock as an example, with this chart:

Some are not seeking opportunity because they are worried about possible market declines. If that is your situation, you have plenty of company. This is one of the problems where we can help. It is possible to get reasonable returns while controlling risk. You can get our report package with a simple email request to main at newarc dot com. Also check out our recent recommendations in our new investor resource page — a starting point for the long-term investor.  (Comments and suggestions welcome.  I am trying to be helpful and I love and use feedback).

Final Thought

This week brought some pushing back against the “Fed haters.” Maybe it was the extra time to muse that I highlighted in last week’s WTWA!

Here are two examples:

1. Cordell Eddings notes that potential bond investors missed a $1 trillion return.

2. Joe Weisenthal wrote provocatively that it might be the “final humiliation” of the Fed haters. This earned him a CNBC debate with Peter Schiff where they employed the instant scoring feature. You can watch it yourself and cast your own vote. Weisenthal wrote as follows:

   Over the last several years, anti-Fed “policy bears” have been warning about how the extraordinary steps taken to juice the economy would end in disastrous.

   Some predicted surging interest rates. Some people predicted runaway inflation. And a lot of folks said that the Fed was murdering the dollar.

   Well, none of that has happened. And not only that, the dollar is one of the strongest currencies in the world.

The CNBC debate, where Schiff scored a narrow victory, tells us more about the audience than the merits of the arguments. There are two distinct time frames for consideration.

• In the short-term, trader time frame there will be a jump in interest rates, including the long end of the curve, with any hint of an accelerated change in Fed policy. The long end, while not directly controlled by the Fed, does react to expectations and the term structure of rates. Related impacts include a stronger dollar and weaker stocks. Mark Gilbert notes that traders tend to over-react.
• In the long term, the Fed policy change is a data-dependent reflection of a stronger economy (assuming that it is not driven by inflation fears). Modestly rising rates are not a threat for stocks as long as the economy is strengthening.

This means that traders must be nimble, prepared to shift with perceptions. Investors who understand the background may get an opportunity to buy another dip. If it reflects recent history, the dip may be shallow.

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